Board Control Over Earnings Management

A board told John Carver that its auditor objected to including a profitability expectation in the board’s Ends, warning that it would create an incentive for earnings management, a collection of practices that usually aims to present a rosier picture than really exists (think of a bit of lipstick on a pig). Some level of earnings management has been an accepted part of management for years. But as important as this subject is, it is surprising that earnings management did not receive a great deal of attention from accountancy until after a 1990 article in Management Accounting by William J. Bruns, Jr., and Kenneth A. Merchant. Here John provides a Policy Governance-based response to these practices.

The auditor took exception to the policy language because, in her opinion, it pressured management toward the practice of earnings management. Before explaining the issue further and outlining the Policy Governance solution, I should be clear that the auditor, in expressing this concern, was doing exactly what she should have done. She was faithfully fulfilling her obligation to the board to make sure that company performance is as reported, uncontaminated by practices that, taken together, have come to be called earnings management. This board felt caught in a struggle with an auditor’s warning and the Policy Governance requirement to make expectations clear and therefore make subsequent evaluation transparent, rigorous, and fair. Earnings management has different definitions and includes actions that are neither illegal nor even violations of Generally Accepted Accounting Principles. Sometimes earnings management is merely a device to “smooth” earnings as they show up from period to period (in other words, a true enough reflection over the long haul, but manipulated quarter by quarter to preserve an appearance of predictability). Let there be no doubt that certain types of earnings management violate some important principles of transparency and ethics.

Therefore, the auditor was correct. Telling management that the board expects at least X profitability gives management an incentive not only to produce that profitability, but also to make management and accounting decisions that gild the lily where it is possible and legal to do so. I’ve heard that Warren Buffet said, “Managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers” (italics mine). But earnings management isn’t necessarily making up the numbers so much as arranging for the numbers to more likely come out advantageously, and it isn’t even necessarily dishonest. Consequently, the problem is not earnings management but some kinds of earnings management.

Suppose management decides to offer discounts on products toward the end of a period instead of waiting until the next period. This affects sales in each period differentially and therefore earnings for each. If management decides to shift to a new, legally mandated accounting practice at the last minute, or long before the deadline date, this may affect how earnings are calculated. If management puts off maintenance of equipment until next period, this action drives up the profit for the first period but drives the next one down. If management posts larger sales in one period on the basis that product returns will be treated liberally in the next period (buy more than necessary from us now, we’ll accept returns later), the profitability will shift to the current period and away from the later one. Although this last example is a bit shady, you can see that these are not necessarily dishonest management practices.

But the types of earnings management do deserve examination by boards of equity companies. See the list in the sidebar, taken from Howard Schilit’s Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports (2nd ed., 2002, McGraw-Hill).

The issue posed in this question is not an irresolvable collision of auditing and Policy Governance. The auditor is exactly right about the possible problem. As for the most effective solution, the auditor does not have the governance tools available in Policy Governance and as a result is recommending a poor solution. In other words, right problem, wrong answer. The auditor sees the solution to be for the board to refrain from setting a profitability expectation in its Ends policies. This solution might take care of the auditor’s worry, but it would betray the board’s trusteeship obligation to shareholders. Remember, auditors are not concerned that your company be profitable; their concern is that your books be trustworthy. The board, however, has both concerns; its interest is in performance and in financial truth. For this reason, although the board should surely pay sober attention to the auditor’s caution, it should not use the auditor’s solution.

What is the Policy Governance approach? It would be to leave the Ends policy as it is, but add a new, carefully worded Executive Limitations policy prohibiting certain earnings management practices. I say “certain . . . practices” instead of earnings management as a whole simply because there may be some the board has no concern about and others that would surely disturb it. The auditor is knowledgeable about the ins and outs of earnings management and so is the best source of wise counsel as the board determines which components of earnings management would be most unacceptable in its own value scheme. In a subsequent action, the board may wish to retain the auditor to do the “external report” monitoring of this policy, say, annually. (“External report” refers to monitoring of a board requirement by an external, disinterested third party selected by the board.)

It is important, however, for the board to remember that it is the Policy Governance expert; the auditor is not and probably does not pretend to be. As a Policy Governance board, it should know that it must take care in what is asked of the auditor when creating an earnings management policy (in the Executive Limitations category of policies, of course). The question is not what solution to employ; nor is the question how to govern. The question is some form of “What practices under the general heading of earnings management do you think the board should find unacceptable?” or “If you were on the board, what would you personally find unacceptable?”

This kind of dilemma, as is the case with many conflicts of ideas, presents a great opportunity for the board to use its Policy Governance education to separate wise warnings from proper solutions. The learning will be useful as the board learns in the future from any number of experts— legal, financial, and otherwise. How to use experts is a valuable skill; most boards have much to learn in this regard. It is easy for boards that do not have a basic governance system to be swayed, and often battered, by varying opinions and input. With Policy Governance firmly and consistently in place, you have a foundation on which to build extensive wisdom over the years that board members continuously appropriate from many sources.